1 Do State Laws Matter for Bondholders? Mansi, Maxwell, & Wald May 22, 2007

2 Introduction This research builds on 2 most recently published papers: – The first by Wald and Long (2006), which examines the impact of state laws on corporate capital structure – The second by Klock, Mansi, and Maxwell (2005), which examines the relation between the Gompers et al. (2003) Index of antitakeover amendments and the cost of debt financing

3 Introduction In this paper, we examine how state laws are valued by the credit markets. We focus our attention on two types of statutory restrictions: – State payout restrictions (restriction on minimum A/D ratio necessary to make a distribution) – Restrictions on hostile takeovers Both of these types of restrictions are designed to protect creditors from expropriation by shareholders and are widely adopted in U.S. debt agreements.

4 Agenda Motivation State payout restrictions and antitakeover laws Current empirical evidence Research questions Sample selection, proxies, and measures Empirical results Conclusion

5 Motivation Main question is whether state of incorporation (or state law) has an impact on firm value Incorporation decision – U.S. firm are all subject to same bankruptcy laws and bankruptcy courts are federal – U.S. firms are subject to same SEC regulation – U.S. firms access same capital markets – U.S. firms pay taxes where they have operations

6 Motivation Evidence on equity side is mixed – Race to the top Empirical evidence for higher firm value for firms incorporating in Delaware (Romano (1985) and Daines (2001)) – Race to the bottom Empirical evidence for insignificant increase in firm value (Subramanian (2004) and Bebchuk & Ferrell (2001), and Bebchuk et al. (2002))

7 What Varies Across States? Laws on payout restrictions – When debt is present, state laws differ in payouts – Few states (e.g., Delaware) provide few restrictions – Firms incorporated in NY, TX and many other states are subject to the net worth rule (TA constraint = 1) – Firms incorporated in CA or Alaska are subject to a more stringent test (TA constraint = 1.25)

8 Can Debt Covenants Substitute for State Laws? State payout restrictions are similar to certain bond covenants, but they are not individually negotiated Firms used to write separate debt covenants But that can be costly (Smith and Warner, 1979; John and Kalay, 1982) After 1980 or so, many of the basic restrictions were added to state laws (Eisenberg, 1983)

9 What Varies Across States? Antitakeover Laws – Companies are only subject to the statutes of the state which they are incorporated – Firms prefer to reincorporate in states with more antitakeover provisions, often to the detriment of shareholders (see Heron and Lewellen, 1998; and Bebchuk and Cohen, 2003) – State antitakeover laws: antigreenmail laws, control share statute, fair-price statute, freeze-out or business combination statutes, poison pills, constituencies statutes

10 State of Incorporation Why do firms remain incorporated in more restrictive jurisdiction – High cost of reincorporation – Regulatory advantages in some states – Payout restrictions may reduce the agency cost of debt by restricting financial and investment policy

11 Costs of Reincorporation For state payout restrictions to matter, the cost of reincorporation can not be too small – otherwise no credible pre-commitment On the other hand, if the cost of reincorporation are too high then firms remain incorporated in their home state, never change states, and do not get optimal use of state laws

12 Empirical Evidence Agency cost of debt – Jensen and Meckling (1976) and Myers (1977) – Conflicts center on firm payout policy (e.g., Dhillon and Johnson (1994); Maxwell and Stephens (2003)) – Antitakeover provisions (e.g., Billet, King, and Mauer (2004), Klock, Mansi, and Maxwell (2005), and Saffieddine and Titman (1999))

13 Empirical Evidence Payout restrictions and state antitakeover laws – Wald and Long (2006) – Heron and Lewellen (1998) – firms prefer to incorporate in states with more antitakeover laws, and these laws decrease firm market values – Bebchuk and Cohen (2003) – similar findings, and also firms prefer to stay in their home states

14 Why Bonds? Debt represents the main source of financing for firms Empirical evidence based on equity prices Tobin Q is typically based on book rather than market value of debt Bond characteristics are well suited for better pricing

15 Research Questions Two main questions – Are there advantages to firms incorporated in states with more restrictive payout jurisdictions? – What is the impact of payout restrictions and state antitakeover laws on credit ratings & yield spreads? In our paper, we find that – Firms incorporated in states with more restrictive payout statues (New York) have better credit ratings and lower spreads relative to firms in less restrictive states (Delaware).

16 Sample Selection  Data sources – Lehman Borthers Fixed Income database – IRRC data on firm decisions to opt out of state laws – State laws from a number of sources, Lexis/Nexis, Gartman (2000) and McGurn et al (1989) for antitakeover laws – Compustat Industrial database (SIC codes ) – Executive compensation database – Thomson Financial (institutional ownership data) – Mergent data for firm reincorporation decisions and fixed income data for debt covenants

17 Selection criteria Based on firms in the LBFI database Based on financial info. from Compustat Based on firms in Gartman (2000) index Final sample of 8,531 firm-year observations on 1,625 firms (for the period from )

18 Why 1987 on? 1987 US Supreme Court decision CTS Corp v. Dynamics Corp of America clarified that antitakeover laws were constitutional. Many states then passed antitakeover legislation

19 Proxies and Measures Measuring the cost of debt – Yield spread weighted yield to maturity less its duration equivalent Treasury yield Measuring state law and antitakeover variables – Payout restrictions (the minimum asset/debt ratio (0, 1, 1.25)) as in Wald and Long (2005) – Antitakeover laws as in Bebchuk and Cohen (2003) – GIndex as in Gompers et al. (2003) or a subset based on Bebchuk et al. (2005).

20 Control Variables Firm Specific – Size, Leverage, MTB – Profitability – Intangibles – Firm Risk Debt Covenants – Event Risk – Payout – Financing Security Specific – Credit Ratings – Duration – Convexity – Debt Age Governance – Inside Ownership – Inst. Ownership

21 Incidence of State of Incorporation

22 Results Most of the firms in the sample are incorporated in Delaware (about 55%) This is because Delaware firms are more likely to use debt financing. Most of the firms in the sample have TA constraint variable of 1.0. Exception is Delaware (TA=0) and California (TA=1.25)

23 Descriptive Statistics

24 Correlations

25 Multivariate Analysis We examine the relation between state laws and antitakeover measures and credit ratings/cost of debt and various controls for firm specific variables We control for clustering and heteroskedasticity as in Peterson (2006)

26 Credit Ratings and State Laws

27 Credit Ratings Results In all specifications, a larger (more strict) TA constraint is associated with a significantly higher credit ratings For Model 1, a TA constraint of 1 is associated with a ratings increase of 0.552, more than half a rating step Changes between models due mainly to smaller sample sizes

28 Yield Spreads and State Laws

29 Yield Spread Results Results suggest that the overall total asset constraint variable is negatively related to the cost of debt financing The index of antitakeover laws variable has no significant impact on bond yields

30 Robustness Checks

31 Conclusion We provide evidence that more stringent payout constraints in state laws have a negative impact on bond yield spreads State laws that restrict firm payouts can reduce the firm’s cost of debt These restrictions function similar to how Smith and Warner (1979) describe the function of debt covenants The impact of antitakeover laws on bond yields is insignificant